Terrel Once Said

[Eli]

i) Joe gets hit by the proverbial Fed Ex van delivering Stephen Vertin MAI's appraisal.
ii) Nobody understands Joe's silly business anyways, especially not his bankers. Under the UCC filings the creditors are now packing up the equipment.
iii) Joe's widow hires a professional broker to sell the real estate.
iv) How much is the market going to pay for this industrial building positioned on a 5 acre parcel.

That is where you have to be careful on what the client wants. But, otoh, know what was included in the sales and rent comps. The ff&e and other interests (tangible and intangible) are usually included in those comps.

 

[leasedfee]

leasedfee said The market determines the entrepreneurial incentive (EI).

The market determines everything, and every component and sub-component in an appraisal: Yields, rates, residuals, allocations, ratios, time, shapes, forms, locations, costs, premiums, discounts, and values.

• EI is ex-ante -- before the event, pro-forma, anticipation.
• EP is ex-post -- after the fact, empirical, actual.

EI is simply the minimum rate demanded by people capable of developing buildings and with access to capital. Otherwise, they'll go play golf. You buy a stock with the anticipation and hope that it'll go up, hopefully say like it has during its prior 1, 3, 5, or 10 year period, or some other logic. If you didn't anticipate a profit, you would've done something different.

EP is the actual empirical result. I appraised a historic renovation project four times over six years, and each time the costs went up and up and up, partly because each new building inspector had different demands. Fortunately, the market was going up and up and up. At year 6, the developer's actual EP was $0, or 0%. Market appreciation saved their butts. At day, upon acquiring the shell building, their EI expectation was somewhere between 10% and 20% profit. Had they known that their EP was 0%, they would've bought bonds or an S&P 500 Index.

 

[Eli]

If I had a clue what the H&B use in a very specific way was on this property, I could help more. That is the missing link.

 

[leasedfee]

That is where you have to be careful on what the client wants.

I don't disagree that there are going concerns where the TAB (total assets of the business) has to be valued, like hotels, car washes, nursing homes.

These property types generally are the exception, not the rule. I recall someone I was proofreading. She insisted that "The machines are bolted to the floor". She argued, therefore, that the valuation had to include the business and use business like comps. I tried, and failed to convince her, that the bolts could be quickly cutoff with a blow torch, or such, and the equipment shipped away. And the next user would bring in unrelated equipment. Happens all of the time. I tried to make her job easier. I tried to convince her to see past the seemingly permanent and to see the property for its real estate components: Land + Building for the next user. Think of how many times we see a building get turned-over and turned-over and turned-over. Equipment is very transient.

 

[Eli]

I don't disagree that there are going concerns where the TAB (total assets of the business) has to be valued, like hotels, car washes, nursing homes.

These property types generally are the exception, not the rule. I recall someone I was proofreading. She insisted that "The machines are bolted to the floor". She argued, therefore, that the valuation had to include the business and use business like comps. I tried, and failed to convince her, that the bolts could be quickly cutoff with a blow torch, or such, and the equipment shipped away. And the next user would bring in unrelated equipment. Happens all of the time. I tried to make her job easier. I tried to convince her to see past the seemingly permanent and to see the property for its real estate components: Land + Building for the next user. Think of how many times we see a building get turned-over and turned-over and turned-over. Equipment is very transient.

Yes, 50% ff&e is serious. But I don't have a problem with EI if my sales and rent comps include ff&e or whatever interests and I disclose the facts. He is on the cost approach and needs an estimate of EI. Now, where does that come from?

 

[Terrel L. Shields]

o did Terrel have it right that EI/EP its a fantasy? Yes, IMO.

Not so much I think it a fantasy, rather it cannot be captured until the first sale, hence gets depreciated. Rather, what is really the potential for bogus is the excess profit above EI. The incentive is there in commercial buildings, but it can go away as quickly as it comes. Orderly liquidation values are another factor. But that surplus earnings is so ghostly, well...they don't call it blue sky for nothing.

Since I know ag best, say you are operating a farm with a chicken contract. The contract is why you built the barns. Lose the contract and what happens? Well, when there is a surplus of birds (meat on the market) then obtaining a new contract is very difficult. The property is distressed and an orderly liquidation is going to be low. But when a farm is about to lose a contract in a building spree, the barns may bring just as much as if they had a contract because there are competitive contract available and the only issue with functionality would be any change to the barns the new contract integrator offers (sometimes they require more fans or stupid stuff like moving the water lines 2' to one side or the other..or additional feed bins.)

So I will value the property on its income potential most likely under the assumption the contract continues and that is the total property value. Excess land isn't going to change in value...I adjust the land. So in those high demand times, the real property and total property values are near unity. But when contracts are scarce, the total property value (and contracts) do not change. But the real property value would be less, so where can I allocate that elastic difference except to BEV?

The poultry equipment is a separate issue because it is much shorter lived than the barn itself. And half the value is in equipment. Some lasts only 7-10 years, most about 15 years and the barn can last 30 easy but desired configuration means there is yet another element of functional obsolescence. Everyone with pole barns in 1970 were told to build steel truss barns and cross ventilation and curtain walls. and then in 2000 told to build wood post and beam barns, solid wall with scissor trusses (wood) and tunnel ventilation (suck air from end to end). It is a convoluted mess...you have to work thru the comps and pick the closest proxy to the subject.

 

[leasedfee]

EI. Now, where does that come from?

Eli, there is no doubt that EI is a squishy vague hazy nebulous and imprecise factor. Determining depreciation is nearly a science in comparison.
In practicality you have to figure it out, by (A) looking at historical profit margin surveys, in libraries, (B) talking to developers, and then talking to more developers, and extraction (which is actually measured EP that a market that appears to be in balance, and concluding that that is representative of developer motivations at stability or at reasonable growth). Sometimes, the extraction method is as crude as determining a strong SCA and IA and then imputing (reverse engineering) the EI. Then applying that knowledge down the road to your next appraisal. "Credible" and "reasonable" remains key to making such judgments. Track housing seems to extract to about 6%-8% EI, and this reconciles with the IRS and S&P business P&L studies. Office and industrial seems, in my market, to extract to about 12% to 15% EI, taking into consideration as a soft-cost the lease-up rent-loss until it is stable, and this seems to reconcile with what developers are quoted to say in private and in public. I would love to be corrected by more knowledgeable people . . . . . Alas, real estate data is mired in medieval astronomy-astrology-and-alchemy.

 

[leasedfee]

Since I know ag best, say you are operating a farm with a chicken contract.

How long are chicken contract terms? How volatile or stable is the demand/growth of chickens/eggs? Is it the government making these building structure demands, or Kroger/Safeway demanding higher food safety, or is it Tyson, etc.? There was a Frontline show about acute salmonella poisoning. It freaked me out so I quit eating chicken for a couple of weeks and mostly ate beef (I know, I know, . . . . ), until I forgot about it.

. . . I can certainly imagine that there are no alternative economic bases in your rural market to absorb an industrial/farm building, so the external obsolescence would hit very hard, until chicken contracts come back online. And the functional obs would be permanent, I presume, on an otherwise fine building.

 

[Terrel L. Shields]

Markets come and go, since I started appraising there have been 4 distinct cycles, 1994, 1999, 2004, and 2013. The last is in late stages. We will see those early barns (1994) likely cease as they are 40'x400'. The 1999 change was to 42'x500' barns part steel truss, part (later) wood truss, then 55'x600' and wood truss. Contracts vary. five to seven for new barns and older than that it is batch to batch contracts (so it is hard to say the contract is adding the value) based on you being a good operator. If you don't do what they say, they terminate the contract. So barns are easiest sold in the first 3 years of life...and harder to sell at year 5 or 7. Normally a buyer would get a new contract if they make the upgrades the integrator requests.

Egg rules from California has reduced the use of caged hens everywhere. Broilers not so much but the main problem with contamination is the lack of sufficient meat inspectors to inspect sufficient quantities of birds. The bulk of research is about food safety. Salmonella is everywhere, so it is cleanliness issue, not a barn issue. And that is a processing plant problem. Bird flu is an issue but is normally carried in by wild birds. Ducks carry it and rarely get sick from it. Most growers are forbidden to go duck hunting and bring the birds back to the farm. A nearby farm has crops and the employees there were told not to hunt dove over those fields when we had a scare in MO.

 

[hastalavista]

In the Cost Approach, Ei is a cost. Just like contractor profit is a cost. MSV estimates typical contractor costs in its RCN data; they do so by surveying contractors as well as reviewing builder contracts. Appraiser's need to estimate EI. Appraisers can do so by surveying developers (as I do). Both contractor profit and EI is depreciated over time. In the context of the cost approach, EI for the improvements are not attributable to the land, because once the improvements are fully depreciated, so is any EI that is attached to them.

I hear the argument that EI is not applicable to homes a lot. At least one person in my residential cost approach argues that the owner who is building their own home doesn't require EI. I find this position to be logically as well as economically unsupportable. Sometimes the person will tell me, "Well, an owner-user who is building their own home will spend the money that a developer would make on additional upgrades to the home they are building?" That is a logical inconsistency because if that were the case, one is not comparing like for like. Here is the thought problem I pose:

Assume YOU have a choice. You can
A. You are highly confident that you can build the home you want for $500,000. This includes everything (land + improvements). It will take 9 months to do so. You assume all risks as the developer.
B. You can buy the exact same house for $500,000 (no uncertainty) and let someone else take on all those risks. All you are doing is purchasing the house that you want that is complete and ready to go.
There are no differences between the two houses or sites, or location. They are exactly the same (like for like).

Under option A, you'll have to manage the process, assume all the risk for something going wrong in the 9-months it takes to construct the improvements as well as the market risk for something changing until it is complete.
Under option B, you have no market risk prior to the purchase, no construction risk, and other risks.
The only risk both homes share is what happens after they are purchased.

I ask the class:
Given choices A or B, which would you choose?.
The answer is almost invariably, I'll pay $500k with no risk and no headaches if the two houses are exactly the same.

​

Then I'll ask, Ok. Would you take option A if you think you could do it for $495k vs. the $500k option B?
Typically, the answer is, "No. I'll pay $500k. It isn't worth a $5k discount to assume all that risk."

I then ask, "What about $490k? What about $480k? What about $470k?, etc.?"

I start getting takers around $480 and almost everyone has signed on by $450k to $460k.

That is EI. That difference (4% to 10%) is what it would take to motivate (incent) the participants (appraisers) in my classes to take on the project. The project that is worth $500k will be self-developed if they can do it for at a cost of 4-10% less than what it will be worth. And this is a hypothetical where no money is actually at risk. When it comes time to put up real money, their risk tolerance may be a bit higher and require more incentive.

Most rational players, being fully informed of the risks, given the choice between purchasing a home already built and going through the process of building that same exact home on their own, which will be worth the same $500k when all is said and done, will choose to pay the $500k for what is done and avoid all headaches and risks of finishing an alternative house that is exactly the same and will cost them the same $500k.
Enough rational players, being fully informed of the risks, would take on the risks of building the house themselves if they can do it for $450k; 10% would motivate almost all the participants in my class to take on the risk.

It doesn't matter (in the cost approach) if they actually make 10% when all is said and done. They could make more or less. What they actually make when all is said and done is their Entrepreneurial Profit.
What does matter is how much they need to be incentivized to take on the risk. That is a cost included in the Cost Approach because without it, the indicted value will not be market value (the CA will produce an indicated value lower than what the market value is because the market requires EI as a cost component of the Cost Approach).
EI must be depreciated over the life of the improvements. If not, it would flow to the land. But land is valued at its H&BU as-vacant and ready for development. Ready for development means no improvements. EI is a cost associated with developing the improvements*. It is earned through the construction and completion of the improvements and it is depreciated over the life of the improvements.

*Sites in the cost approach are "vacant, ready for development". Raw land may not be a site and there is certainly EI earned by getting raw land to a site, ready for development. That is already baked into the site value in the cost approach.